Yum! Brands Inc. Q3 Earnings: China Food Scandals Still Dragging on Sales

A second food scandal in as many years has made it difficult for Yum! Brands toregain its footing in China.

Investors finally lost patience with Yum! Brands after the restaurant operator's most recent quarterly report on Tuesday afternoon showed underwhelming results in China, where management finally admitted its recovery is taking longer than expected. Shares of Yum!, which owns the Taco Bell, KFC, and Pizza Hut chains, were down nearly 19% at 11 a.m. Wednesday.

Although same-store sales in China finally turned positive, rising 2% over the year-ago period, Yum! Brands has been unable to sufficiently rise above the muck created by its second food safety scandal in as many years there. The restaurant chain had predicted that it would be able to bounce back in the second half of 2015 and hit its earnings growth target of 10%, but the pace of its sales recovery is going slower than management anticipated. It now expects to achieve only low single-digit growth.

This was a surprise?While the markets reacted negatively to the news as if this were a huge shock, investors who have watched the Yum! story play out already knew the rebound wasn't going according to script. Last quarter, CEO Gary Creed said he still maintained hope the back half of the year would be strong, but admitted the company's China turnaround was taking a long time. This quarter's results are merely confirmation that when you poison the well of goodwill too many times, it's hard to earn back trust.

Yum! Brands reported worldwide system sales grew 6% in the third quarter, with revenues hitting $3.4 billion. Year to date, though, total revenues are down 1% from the same period in 2014.

Operating profits rose 10% to $603 million and net income rose 4% to $421 million, or $0.95 per share, a 6% increase over the year-ago period. But again, year to date, all those numbers are still down, and with China still roiling the waters, management was forced to concede its previously rosy outlook was no longer realistic.

Beyond the China market, which admittedly remains the most critical aspect of Yum! Brands' performance -- even with the weaker-than-expected results, China still accounts for 53% of total revenues and 45% of operating profits -- the various chains were reporting robust business.

A hearty serving of growthComparable-store sales at Taco Bell, KFC, and even Pizza Hut were all positive this quarter. Taco Bell's comps were up 4%, helping to drive system sales 7% higher; KFC's were up 3%, leading to a 3% increase in system sales; and Pizza Hut saw a 1% rise in comps as system sales rose 2%.

Therest of Yum! Brands' restaurants have been performing well, particularly the Taco Bell chain, whichreported another quarter of strong comparable-store sales growth.

Yet Yum! Brands has been marketing the heck out of its restaurants, a fact that was reflected by the decline in operating margins at all three chains this quarter, though by less than 1%.

However, restaurant margins -- the profits of each restaurant divided by its sales -- were almost universally higher. Taco Bell saw a 1.4-percentage-point increase, while KFC's margins were up 0.6 percentage points. (The report was silent on Pizza Hut.)

One other area the restaurant operator has been pouring money into is India, but the world's second-most populous nation is seemingly a lost cause for Yum! Brands. Though it opened some 80 new restaurants there, sales were down 9% in the quarter there as comparable-store sales plunged 18%, yet another in a long string of quarters of double-digit declines. The division's operating losses more than doubled to $8 million.

India is such a small component of the overall business that it's not having a noticeable impact on the company's results, but with its China business sluggish, Yum! Brands' attempts to gain a toehold in the market are at best a distraction. Right now, India is just a money pit.

A recipe for changeThe third quarter's results, however, may give Yum! Brands' activist investors new impetus to calve off the China division. Earlier this year, Corvex Management and Third Point Capital took substantial positions in the restaurant operator and have advocated spinning off the China business, both to enhance shareholder value and to reduce the company's risk. With the slow-healing nature of its reputation wounds in China becoming clearer, we could see the hedge funds agitating for the company to do something more -- soon.

However, as this quarter's results indicate, despite the plodding pace at which it's occurring, China is gradually warming up to the company's restaurants again. It's only a matter of time before Yum! Brands has recovered its footing there. And that suggests the big selloff in the restaurant operator's stock may have created a good buy-in opportunity.

The article Yum! Brands Inc. Q3 Earnings: China Food Scandals Still Dragging on Sales originally appeared on Fool.com.

Rich Duprey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.